At a panel discussion in Moscow this past October, Russian oil baron Mikhail Khodorkovsky touted the vast oil reserves in his country. Some experts even considered them grossly underestimated, he declared.

Seated with him onstage was
Exxon Mobil Corp.
Chief Executive Lee Raymond, who was in the midst of undisclosed talks to buy a big piece of the company controlled by Mr. Khodorkovsky. "Geologists are optimistic and often wrong," Mr. Raymond said later in the session.

Exxon's hopes for a transforming payday in Russia were about to be darkened. As the conference unfolded, police armed with machine guns were surrounding Mr. Khodorkovsky's house. The police action was part of a probe by Russian prosecutors that subsequently would land Mr. Khodorkovsky, 40 years old, in a Moscow jail on allegations of fraud and tax evasion, where he remains. The businessman, whose oil company is Russia's biggest, maintains the charges are false and politically motivated.

Exxon and many other Western oil companies had big ambitions when they flocked to Russia looking for deals after the collapse of communism in 1991. Once the world's largest oil producer, the former Soviet Union represented the biggest new opportunity for the world's oil companies in a generation.

But the story of Exxon's delicate dance with Russia shows that the opportunity has been much more elusive than the oil giants and the Western political leaders hoping for an alternative to Middle Eastern oil envisioned. Russian President Vladimir Putin, whose methodical strengthening of Kremlin authority has fueled fears he is undermining democracy, has increasingly sought to keep the state's hand in the oil industry, which was almost completely privatized in the 1990s.

For Exxon, the ultimate prize was to have been a $25 billion-plus deal for a big stake in OAO Yukos, the publicly traded company controlled by Mr. Khodorkovsky. Now, Russian prosecutors have frozen Mr. Khodorkovsky's stake in Yukos, including the shares Exxon planned to buy. The probe is widely viewed as a Kremlin effort to rein in the political ambitions of the executive, who was funding a broad range of rivals to Mr. Putin. Mr. Putin has denied any political motivation.

After Russian tax authorities earlier this month slapped Yukos with a bill for $3.5 billion in back taxes -- charges Yukos is fighting -- a consortium of banks warned Monday that the move could put Yukos in default on a $1 billion loan. (See related article.)

Exxon also has encountered other setbacks. In January, the Russian government unexpectedly threatened to strip the company of the license for a planned companion project to a $12 billion oil-drilling venture under way in the icy waters of the Pacific near Sakhalin Island.

Exxon is seeking to keep the license in place and remains committed to expanding in Russia. "When you're the largest private oil company in the world, you can't not be interested in the country with the largest resources" available to Western companies, says Rex Tillerson, the Exxon executive who has headed the Russian campaign. He recently was named Exxon's president.

President Putin maintains that Russia welcomes foreign investment, but business executives and senior Russian officials say the Kremlin wants a major role in how investments are made in strategic sectors such as oil.

Some foreigners have found their way to deals in Russia.
BP
PLC says its $7 billion joint venture, concluded last year with TNK International Co., is on track and could substantially boost its reserves. But many in the industry, including within BP, say the Kremlin appears unlikely to allow foreigners to make such large deals in the future.

U.S. officials privately acknowledge that highly publicized efforts to diversify energy sources by cooperating with Russia have largely turned out to be a dry hole. Exxon officials declined to comment on anything related to a possible Yukos pact. The Kremlin press office declined to respond to a detailed request for comment.

With communism's collapse, many oil companies looked to the old Soviet Union's tundra, seeing some of the biggest new opportunities of a generation. While many nabbed what appeared to be official approvals for large projects in those early years, turning them into workable contracts proved difficult amid red tape and regular shuffles in the Russian government.

Turning Point

Discouraged by the obstacles, Mr. Tillerson in the late 1990s scaled back the team working on Exxon's first Sakhalin Island oil-drilling project. Exxon turned its attention to a project in Chad. But a turning point came in 2000. "When Putin came on board, things really started coming together," Mr. Tillerson recalls. For the first time, he says, government officials seemed genuinely interested in moving the Sakhalin project forward. Mr. Tillerson led a group within Exxon pushing to spend the billions it would take to proceed with commercial development. By the middle of 2001, after long internal debate, his view prevailed.

Because Russia has a highly developed oil industry of its own, the Western giants could choose between investing in new projects such as Exxon's off Sakhalin Island or buying into Russia's oil companies to get access to their reserves. By late 2001, the young billionaires who had picked up most of these companies from the state in the chaotic privatizations of the 1990s were growing ready to sell.

In February 2002, Mr. Khodorkovsky took his sales pitch to the heart of the U.S. oil industry. Ex-President George H. W. Bush hosted a get-acquainted session for the young Russian tycoon with U.S. oil executives over iced tea at Houston's exclusive Forest Club.

Some of what the brash businessman said wasn't what his U.S. peers wanted to hear. He openly acknowledged his intent to fight Western-backed legislation to allow foreign oil companies to lock up Russian reserves in deals with the government, bypassing companies such as Yukos. In a measure of his clout at the time, Yukos's lobbying efforts within a year had all but eviscerated the legislation.

Mr. Khodorkovsky also tried to build political momentum for U.S.-Russia oil deals. He was one of the few prominent Russians to question Mr. Putin's opposition to the war in Iraq, pointing out that long-term cooperation with Washington would be far more valuable for Moscow.

Just weeks after the second President Bush and President Putin discussed the need for greater energy cooperation at a Moscow summit in May 2002, Yukos was loading Siberian crude for the first such shipment to the U.S., complete with a news conference in Houston when the tanker arrived. Exxon bought that first cargo.

A few months later, Yukos officials were participating with other big oil executives in an energy summit in Houston backed by Presidents Bush and Putin. After a private tour of Exxon's research center, Mr. Khodorkovsky donned newly acquired cowboy boots and hat, and rode out on horseback into the ring of a rodeo. Though he didn't ride a bronco, he did try his hand in a contest tossing dried chunks of manure.

Talks with major oil companies intensified over the summer and fall of 2002, and Mr. Khodorkovsky began to seriously consider selling a Yukos stake as large as 25%. At the time, he and associates owned at least 60% of the company.

Yukos considered a deal with BP. But the British oil giant decided by spring that it wanted a bigger role in management than Mr. Khodorkovsky appeared ready to offer. BP then stepped up talks with TNK International, a smaller oil company.

The political stars also were aligning for the deals. At a summit near St. Petersburg in November, Presidents Bush and Putin discussed the possibility of tie-ups between large U.S. and Russian companies. They saw it as a suitable extension of their close political relationship and burgeoning energy cooperation.

But a key issue was emerging for the Kremlin, which was only too aware of the importance of the oil industry to Russia's economic -- and thus political -- stability. Together with natural gas, oil accounts for as much as a quarter of Russia's economy, according to the World Bank.

Questions of Control

"The main questions were about control: Who will have control? Will they have it? Or will you?" Mikhail Fridman, one of the biggest shareholders in TNK, recalls of a conversation he says he had with Mr. Putin just before BP last year signed its $7 billion pact with the oil company. Mr. Fridman says the president appeared reassured that BP's stake in TNK would be held to 50%. Another TNK shareholder present at the meeting points out that Mr. Putin wasn't explicit about his views on how much either side should own, but seemed interested in how the company would be run, since neither side had outright equity control.

Mr. Khodorkovsky also talked to the president about his plans, seeking official blessing to sell a minority stake, all he was considering at the time, according to people close to Mr. Khodorkovsky.

Meanwhile, to move along its Sakhalin project, Mr. Tillerson says he brought a photo to a meeting with the Russian prime minister of the 41,000 pages of documents Exxon had been required to prepare by Russian bureaucrats under President Putin. Authorities gave it the official go-ahead earlier this month.

Top Exxon executives also were growing increasingly serious about the possibility of buying into a Russian company. Following announcement of BP's pact, top Exxon executives told associates that the company would insist on a controlling stake in order to protect its investment.

Mr. Khodorkovsky was now more willing to consider a deal under which he would cede control, over several years. The stake he and his associates held was about to shrink to 44%, once the firm's newly announced acquisition of Russian rival OAO Sibneft was completed, but its value already had swollen to more than $30 billion. Tensions with the Kremlin over Mr. Khodorkovsky's funding of political opponents had boiled over with the July arrest of a close Khodorkovsky associate, providing another motivation for limiting his Yukos interests, according to a person close to him.

At a U.S.-Russia energy summit in St. Petersburg in September, Mr. Tillerson refused to comment on media reports of talks with Yukos. But he praised Russia's improving investment climate. "On balance, I feel more comfortable committing to massive, long-term investments," he said.

A few days later, Mr. Putin met top U.S. business leaders at the New York Stock Exchange. While other executives settled for a group session around a massive dark-wood conference table, Exxon's Mr. Raymond was granted a personal conversation with Mr. Putin. He emerged from it encouraged about the prospects for a Yukos deal, according to people familiar with the conversation.

In early October, Exxon's Mr. Raymond traveled to Moscow, where he spoke on the panel with Mr. Khodorkovsky at the business conference. That morning, Yukos announced the completion of its merger with Sibneft. Neither Mr. Raymond nor Mr. Khodorkovsky would comment on news reports that they were close to a deal under which Exxon would buy as much as 40% of Yukos. In fact, Exxon was closing in on a deal for an even bigger stake, according to people familiar with the situation.

As they prepared for the session, the panel's moderator went over with his guests the questions he planned to raise during the discussion. Among them: What is the best model for foreign oil companies to invest in Russia: minority stakes in Russian companies, 50-50 partnerships such as the BP-TNK pact or start-up projects such as Exxon's Sakhalin oil field? "I don't think it's a really good idea to have any kind of a minority investment in Russia," Mr. Raymond answered, according to a person present.

After the session, where the exchange about Russia's oil reserves took place, Mr. Khodorkovsky was asked if the Kremlin would allow him to sell a majority stake. "Political realities here change every day," he said.

Moments later, as most panelists and audience members crossed the hall for a speech by President Putin, Mr. Khodorkovsky got an urgent cellphone call from his wife. She told him their house was surrounded by police.

Mr. Khodorkovsky rushed home. In the end, police searched a house near Mr. Khodorkovsky's, and confiscated computers from Yukos offices and a boarding school funded by the company. They made no move to arrest Mr. Khodorkovsky or search his home, however.

Mr. Raymond, meanwhile, pressed on with his dealmaking. At a meeting at Moscow's White House with Prime Minister Mikhail Kasyanov, he asked how the government would view Exxon's purchase of a large stake in Yukos; it is unclear whether he specified how large a stake. He was told "the Russian government doesn't see any legal obstacles to it," according to a Russian official familiar with the session. Mr. Raymond also had a private meeting with the Russian president, where he similarly discussed a possible large Yukos position, according to several people familiar with the meeting.

In an interview published that day on the Kremlin's Web site, Mr. Putin was asked his view of Exxon buying 40% of Yukos. Mr. Putin said he would support Exxon's activities, but that "it would be right" for Exxon to consult in advance with the Russian government on such a large deal. Russian oil-industry executives detected a cautionary tone, but Exxon officials remained confident their deal was on track, according to people familiar with the situation.

Mr. Khodorkovsky held a defiant news conference at Yukos's new Moscow headquarters the Monday after the police searches. "If the goal is to drive me from the country or put me in jail," he told a room packed with TV cameras and reporters, "they'd better put me in jail."

On Oct. 25, they did. Heavily armed agents stormed onto his rented jet at a refueling stop in Siberia. He was flown back to Moscow.

The news rattled business executives both inside and outside the country, amid widespread concern that the case was politically motivated and signaled a sharp worsening of the business and investment climate. Just over a month later, President Bush raised Washington's concerns about the Khodorkovsky case in a phone conversation with Mr. Putin. Sibneft's main shareholders, meanwhile, began trying to back out of their merger with Yukos.

For Exxon the bad news mounted: The Kremlin signaled that Exxon's talks would have to wait until Mr. Khodorkovsky's legal problems are sorted out. Russian oil officials close to the Kremlin told Westerners that Moscow wouldn't allow deals in which foreigners gained control of a Russian oil company. Then a government commission in late January said the second Sakhalin project would probably have to be put up for bid again.

Exxon remains interested in a Yukos deal, according to people familiar with the situation. Of oil activities in Russia generally, Mr. Tillerson says, "it feels kind of painful and ugly today, but it's still heading in the right direction."